U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________ to __________.

For the period ended June 30, 2008

Commission file number 001-31972

TELKONET, INC. 

(Exact name of Issuer as specified in its charter)

Utah
87-0627421
 (State of Incorporation)
 (IRS Employer Identification No.)

20374 Seneca Meadows Parkway, Germantown, MD 20876
(Address of Principal Executive Offices)

(240) 912-1800
Issuer's Telephone Number

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.       Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, and accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act, (check one).

Large Accelerated Filer  o
   Accelerated Filer  x
  Non-Accelerated Filer  o

Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act.  o Yes   x No

Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 81,519,456 shares of Common Stock ($.001 par value) as of August 1, 2008.
 
 
 
 
 
 
TELKONET, INC.
FORM 10-Q for the Quarter Ended June 30, 2008

Index

 
Page
   
PART I. FINANCIAL INFORMATION
2
   
Item 1. Financial Statements (Unaudited)
2
   
Condensed Consolidated Balance Sheets:
2
June 30, 2008 and December 31, 2007
  
   
Condensed Consolidated Statements of Operations and Comprehensive Loss:
 3
Three and Six Months Ended June 30, 2008 and 2007
  
   
Condensed Consolidated Statement of Stockholders’ Equity
 4
January 1, 2008 through June 30, 2008
  
   
Condensed Consolidated Statements of Cash Flows:
 5
Six Months Ended June 30, 2008 and 2007
  
   
Notes to Unaudited Condensed Consolidated Financial Statements:
 7
June 30, 2008
  
   
Item 2. Management’s Discussion and Analysis
 28
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 40
   
Item 4. Controls and Procedures
 40
   
PART II. OTHER INFORMATION
 41
   
Item 1. Legal Proceedings
 41
   
Item 1A. Risk Factors
 41
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 42
   
Item 3. Defaults Upon Senior Securities
 42
   
Item 4. Submission of Matters to a Vote of Security Holders
 42
   
Item 5. Other Information
 43
   
Item 6. Exhibits
 43

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

TELKONET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

ASSETS
  
June 30,
2008 (unaudited)
    
December 31, 2007 (audited)
  
Current assets:
                
Cash and cash equivalents
  
$
224,788
    
$
1,629,583
  
Accounts receivable, net of allowance for doubtful accounts of $190,306 and $111,957 at June 30, 2008 and December 31, 2007, respectively
    
764,260
      
2,134,978
  
Due from receivable factoring
    
633,106
      
-
  
Investment in sales type leases
    
7,995
      
16,501
  
Inventories
    
2,287,648
      
2,578,084
  
Prepaid expenses and deposits
    
1,042,910
      
645,022
  
Total current assets
    
4,960,707
      
7,004,168
  
                 
Property and equipment, at cost:
                
Furniture and equipment
    
1,669,495
      
1,660,493
  
Less: accumulated depreciation
    
923,895
      
809,915
  
Total property and equipment, net
    
745,600
      
850,578
  
                 
Equipment under operating leases, at cost:
                
Telecommunications and related equipment, at cost
    
146,299
      
313,941
  
Less: accumulated depreciation
    
91,439
      
243,894
  
Total equipment under operating leases, net
    
54,860
      
70,047
  
                 
Cable and related equipment:
                
Telecommunications and related equipment, at cost
    
6,622,289
      
5,764,645
  
Less: accumulated depreciation
    
1,856,834
      
1,537,862
  
Total cable and related equipment, net
    
4,765,455
      
4,226,783
  
                 
Other assets:
                
Long-term investments
    
62,803
      
62,803
  
Marketable securities
    
2,982,963
      
4,541,167
  
Intangible assets, net of accumulated amortization of $1,293,677 and $895,085 at June 30, 2008 and December 31, 2007, respectively
    
6,050,437
      
6,449,029
  
Financing costs, net of accumulated amortization of $253,298 and $168,353 at June 30, 2008 and December 31, 2007, respectively
    
1,002,876
      
697,461
  
Goodwill
    
14,670,455
      
14,670,455
  
Deposits and other
    
181,643
      
168,854
  
Total other assets
    
24,951,177
      
26,589,769
  
                 
Total Assets
  
$
35,477,799
    
$
38,741,345
  
         
         
Current liabilities:
                
Accounts payable and accrued liabilities
  
$
8,905,682
    
$
7,354,177
  
Capital lease payable – current
    
36,663
      
-
  
Related party advances
    
691,000
      
291,000
  
Senior note payable, net of debt discounts
    
-
      
1,470,820
  
Registration rights liability
    
-
      
500,000
  
Deferred revenue
    
269,353
      
250,613
  
Other
    
393,879
      
128,222
  
Total current liabilities
    
10,296,577
      
9,994,832
  
                 
Long-term liabilities:
                
Convertible debentures, net of debt discounts
    
4,512,500
      
4,432,342
  
Capital lease payable – non current
    
183,986
      
-
  
Derivative liability
    
2,305,211
      
-
  
Deferred lease liability and other
    
56,900
      
67,112
  
Total long-term liabilities
    
7,058,597
      
4,499,454
  
                 
Commitments and contingencies
    
-
      
-
  
Minority interest
    
3,344,680
      
2,978,918
  
                 
Stockholders’ equity
                
Preferred stock, par value $.001 per share; 15,000,000 shares authorized;
    none issued and outstanding at June 30, 2008 and December 31, 2007
    
-
      
-
  
Common stock, par value $.001 per share; 130,000,000 shares authorized; 80,168,105 and 70,826,544 shares issued and outstanding at June 30, 2008 and December 31, 2007, respectively
    
80,168
      
70,827
  
Additional paid-in-capital
    
116,424,632
      
112,013,093
  
Accumulated deficit
    
(100,168,651
)
    
(90,815,779
)
Accumulated comprehensive loss
    
(1,558,204
)
    
-
  
Stockholders’ equity
    
14,777,945
      
21,268,141
  
                 
Total Liabilities and Stockholders’ Equity
  
$
35,477,799
    
$
38,741,345
  

See accompanying footnotes to the unaudited condensed consolidated financial information
 
2
 
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)
 

   
For The Three Months Ended
June 30,
    
For The Six Months Ended
June 30,
  
   
2008
    
2007
    
2008
    
2007
  
Revenues, net:
                        
Product
  
$
3,994,329
    
$
2,626,079
    
$
7,369,155
    
$
3,263,935
  
Rental
    
1,630,208
      
1,040,528
      
3,214,403
      
1,648,941
  
Total Revenue
    
5,624,537
      
3,666,607
      
10,583,558
      
4,912,876
  
                                 
Cost of Sales:
                                
Product
    
2,407,378
      
1,935,481
      
4,959,317
      
2,364,949
  
Rental
    
1,329,399
      
1,060,408
      
2,619,663
      
1,947,401
  
Total Cost of Sales
    
3,736,777
      
2,995,889
      
7,578,980
      
4,312,350
  
                                 
Gross Profit
    
1,887,760
      
670,718
      
3,004,578
      
600,526
  
                                 
Costs and Expenses:
                                
Research and Development
    
492,689
      
615,205
      
1,157,811
      
1,089,808
  
Selling, General and Administrative
    
3,620,129
      
4,244,707
      
7,205,639
      
8,504,818
  
Impairment write-down in investment in affiliate
    
380,000
      
-
      
380,000
      
-
  
Non-Employee Stock Based Compensation
    
-
      
-
      
81,500
      
-
  
Employee Stock Based Compensation
    
206,432
      
307,425
      
428,630
      
661,611
  
Employee Stock Based Compensation of Subsidiary
    
134,096
      
28,456
      
267,397
      
28,456
  
Depreciation and Amortization
    
256,286
      
211,373
      
512,570
      
362,520
  
Total Operating Expense
    
5,089,632
      
5,407,166
      
10,033,547
      
10,647,213
  
                                 
Loss from Operations
    
(3,201,872
)
    
(4,736,448
)
    
(7,028,969
)
    
(10,046,687
)
                                 
Other Income (Expenses):
                                
Interest Income
    
1,951
      
30,111
      
28,541
      
72,458
  
Financing Expense
    
(703,158
)
    
(66,973
)
    
(1,705,867
)
    
(200,557
)
Gain (Loss) on Derivative Liability
    
(1,018,453
)
    
-
      
(1,018,453
)
    
-
  
Registration rights liquidated damages of subsidiary
    
-
      
-
      
500,000
      
-
  
Other income
    
-
      
-
      
270,950
      
-
  
Other expense
    
-
      
-
      
(1,598,203
)
    
-
  
Total Other Income (Expenses)
    
(1,719,660
)
    
(36,862
)
    
(3,523,032
)
    
(128,099
) 
                                 
Loss Before Provision for Income Taxes
    
(4,921,532
)
    
(4,733,310
)
    
(10,552,001
)
    
(10,174,786
)
Provision for Income Taxes
    
-
      
-
      
-
      
-
  
                                 
Loss Before Minority Interest
    
(4,921,532
)
    
(4,733,310
)
    
(10,552,001
)
    
(10,174,786
)
Minority Interest
    
689,691
      
188,440
      
1,199,129
      
188,440
  
Net Loss
  
$
(4,231,841
)
  
$
(4,584,870
)
  
$
(9,352,872
)
  
$
(9,986,346
)
                                 
Loss per common share (basic and assuming dilution)
  
$
(0.05
)
  
$
(0.07
)
  
$
(0.13
)
  
$
(0.16
)
                                 
Weighted average common shares outstanding
    
77,319,806
      
66,747,862
      
74,583,911
      
62,699,631
  
                                 
Comprehensive Loss:                                 
                                 
Net Loss    $  (4,231,841 )    $  (4,584,870 )    $  (9,352,872 )    $  (9,986,346 ) 
                                 
Unrecognized loss on investment      (1,019,237 )      -       (1,558,204 )      -  
                                 
Comprehensive Loss    $  (5,251,078 )    $  (4,584,870 )    $  (10,911,076 )    $  (9,986,346 ) 
 
See accompanying footnotes to the unaudited condensed consolidated financial information

 
3
 
  
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE PERIOD FROM JANUARY 1, 2008 THROUGH JUNE 30, 2008
 
 
Preferred Shares
  
Preferred
Stock Amount
  
Common
Shares
  
Common
Stock
 Amount
  
Additional
 Paid in
 Capital
  
Accumulated Deficit
  
Comprehensive Income (Loss)
  
Total
  
                                               
Balance at January 1, 2008
-
    
-
    
70,826,544
  
 $
70,827
  
$
112,013,093
  
$
(90,815,779
)
$
-
  
$
21,268,141
  
                                               
Shares issued in exchange for services rendered at approximately $1.09 per share
-
    
-
    
312,911
    
313
    
340,094
    
-
    
-
    
340,407
  
                                               
Shares issued for cashless warrants exercised
-
    
-
    
1,000,000
    
1,000
    
(1,000
)
  
-
    
-
    
-
  
                                               
Shares issued in connection with Private Placement
-
    
-
    
2,500,000
    
2,500
    
1,497,500
    
-
    
-
    
1,500,000
  
                                               
Adjustment shares issued for investment in affiliate
-
    
-
    
3,046,425
    
3,046
    
(3,046
) 
  
-
    
-
    
-
  
                                               
Adjustment shares issued for purchase of subsidiary
-
    
-
    
1,882,225
    
1,882
    
(1,882
) 
  
-
    
-
    
-
  
                                               
Shares issued from escrow contingency in purchase of subsidiary
-
    
-
    
600,000
    
600
    
379,400
    
-
    
-
    
380,000
  
                                               
Value of additional warrants issued in conjunction with anti-dilution provision
-
    
-
    
-
    
-
    
173,640
    
-
    
-
    
173,640
  
                                               
Stock-based compensation expense related to the re-pricing of investor warrants
-
    
-
    
-
    
-
    
1,598,203
    
-
    
-
    
1,598,203
  
                                               
Stock-based compensation expense related to employee stock options
-
    
-
    
  -
    
-
    
428,630
    
-
    
-
    
428,630
  
                                               
                                               
Holding loss on available for sale securities
-
    
-
    
  -
    
-
    
  -
    
  -
    
(1,558,204
)
  
(1,558,204
)
                                               
Net Loss
-
    
-
    
-
    
  -
    
   -
    
(9,352,872
) 
  
-
    
(9,352,872
)
                                               
Balance at June 30, 2008
-
    
-
    
80,168,105
  
 $
80,168
  
$ 
116,424,632
  
$ 
(100,168,651
) 
$ 
(1,558,204
)
$ 
14,777,945
  
 
See accompanying footnotes to the unaudited condensed consolidated financial information
 
4
 
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
For The Six Months
Ended June 30,
  
   
2008
    
2007
  
Cash Flows from Operating Activities:
            
Net loss from operating activities
  
$
(9,352,872
)
  
$
(9,986,346
)
Adjustments to reconcile net loss from operations to cash used in operating activities
                
Minority interest
    
(1,199,129
)
    
(188,440
) 
Registration rights liquidated damages
    
(500,000
)
    
-
  
Write-off of fixed assets in conjunction with loss on sublease
    
-
      
64,608
  
Amortization of financing costs
    
157,096
      
24,050
  
Amortization of debt discount and warrant on convertible debentures
    
285,625
      
62,821
  
Loss on derivative liability
    
1,018,453
      
-
  
Impairment write-down on goodwill
    
380,000
      
-
  
Value of additional warrants issued
    
2,635,144
      
131,009
  
Stock based compensation to employees and consultants in exchange for services rendered
    
1,036,434
      
901,372
  
Depreciation, including depreciation of equipment under operating leases and cable and related equipment
    
965,848
      
711,422
  
Increase / decrease in:
                
Accounts receivable
    
1,357,567
      
(565,758
) 
Due from receivable factoring
    
(633,106
)
    
-
  
Inventory
    
290,436
      
123,323
  
Prepaid expenses and deposits
    
(145,477
)
    
(131,832
)
Customer deposits and other current liability
    
245,389
      
(40,898
 ) 
Accounts payable and accrued expenses
    
1,314,739
      
818,994
  
Deferred revenue
    
13,242
      
(101,501
)
Other
    
8,506
      
10,670
  
Net Cash (Used in) Operating Activities
    
(2,122,105
)
    
(8,166,506
)
                 
Cash Flows from Investing Activities:
                
Costs of equipment under operating leases and cable and related equipment
    
(771,960
)
    
(733,141
)
Investment in subsidiaries
    
-
      
(4,050,557
)
Purchase of property and equipment, net
    
(9,001
)
    
(189,154
)
Net Cash (Used in) Investing Activities
    
(780,961
)
    
(4,972,852
)
                 
Cash Flows from Financing Activities:
                
Proceeds from issuance of convertible debentures, net of costs and fees
    
1,575,000
      
5,303,238
  
Proceeds from sale of common stock, net of costs
    
1,500,000
      
9,610,000
  
Proceeds from subsidiary’s sale of common stock, net of costs
    
-
      
2,694,020
  
Proceeds from exercise of stock options and warrants
    
-
      
111,960
  
Proceeds from officer advances
    
400,000
      
-
  
Financing costs
    
(462,511
)
    
-
  
Repayment of capital lease and other
    
(14,218
)
    
-
  
Repayment of senior note
    
(1,500,000
)
    
-
  
Repayment of subsidiary loans
    
-
      
(200,598
)
Net Cash Provided by Financing Activities
    
1,498,271
      
17,518,620
  
                 
Net Increase (Decrease) in Cash and Cash Equivalents
    
(1,404,795
)
    
4,379,262
  
                 
Cash and cash equivalents at the beginning of the period
    
1,629,583
      
1,644,037
  
                 
Cash and cash equivalents at the end of the period
  
$
224,788
    
$
6,023,299
  

See accompanying footnotes to the unaudited condensed consolidated financial information

 
5
 

TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

   
For The Six Months
Ended June 30,
  
   
2008
  
2007
  
Supplemental Disclosures of Cash Flow Information
          
Cash paid during the period for financing expenses
  
$
175,532
  
$
3,420
  
Income taxes paid
    
-
    
-
  
               
Non-cash transactions:
              
Issuance of shares for purchase of subsidiary
    
-
    
15,756,097
  
Amortization of debt discount and warrant on convertible debentures
    
285,625
    
-
  
Loss on derivative liability
    
1,018,453
    
-
  
Impairment write-down on goodwill
    
380,000
    
-
  
Value of additional warrants issued
    
2,635,144
    
131,009
  
Stock based compensation to employees and consultants in exchange for services rendered
    
1,036,434
    
815,574
  
Registration rights liquidated damages of subsidiary
    
(500,000
)
  
-
  
Capital lease advances
    
226,185
    
-
  
               
Acquisition of subsidiary (Note B):
              
Assets acquired
  
$
-
  
$
2,286,479
  
Subscriber lists
    
-
    
2,900,000
  
Goodwill
    
-
    
15,096,922
  
Liabilities assumed
    
-
    
(1,356,415
)
Common stock issued
    
-
    
(15,756,097
)
Direct acquisition costs
    
-
    
(295,889
)
Cash paid for acquisition
  
$
-
  
$
(2,875,000
)

See accompanying footnotes to the unaudited condensed consolidated financial information

 
6
 

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2008
(UNAUDITED)

NOTE A-SUMMARY OF ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying consolidated financial statements follows.

Business and Basis of Presentation

Telkonet, Inc. (the “Company”), formed in 1999 and incorporated under the laws of the State of Utah, is a leading provider of innovative, centrally managed solutions for integrated energy management, networking, building automation and proactive support services.  Prior to January 1, 2007, the Company was primarily engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of voice and data communications over electric utility lines.

In January 2006, following the acquisition of Microwave Satellite Technologies (MST) (Note B), the Company began offering complete sales, installation, and service of VSAT and business television networks, and became a full-service national Internet Service Provider (ISP). The MST solution offers a complete “Quad-play” solution to subscribers of multichannel video programming, VoIP telephony, NuVision Broadband Internet access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling units and hotels.

In March 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada.

In March 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition enables Telkonet to provide installation and support for PLC products and third party applications to customers across North America.

In May 2007, Microwave Acquisition Corp., a newly formed, wholly-owned subsidiary of MSTI Holdings Inc. (formerly Fitness Xpress-Software Inc.) merged with MST. As a result of the merger, the Company’s common stock in MST was exchanged for shares of common stock of MSTI Holdings Inc. Immediately following the merger, MSTI Holdings Inc. completed a private placement of its common stock for aggregate gross proceeds of $3,078,716 and sold senior convertible debentures in the aggregate principal amount of $6,050,000 (plus an 8% original issue discount added to such principal amount). As a result of these transactions, the Company’s 90% interest in MST became a 63% interest in MSTI Holdings Inc.

In July 2007, MST, the wholly-owned subsidiary of the Company’s majority owned subsidiary MSTI Holdings Inc., acquired substantially all of the assets of Newport Telecommunications Co., a New Jersey general partnership. Pursuant to the terms of the acquisition, the total consideration paid was $2,550,000, consisting of unregistered shares of the Company’s common stock, equal to $1,530,000, and (ii) $1,020,000 in cash.

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc. and Ethostream and 63%-owned subsidiary MSTI Holdings Inc. (reported as the Company’s MST segment). Significant intercompany transactions have been eliminated in consolidation.

Investments in entities over which the Company has significant influence, typically those entities that are 20 to 50 percent owned by the Company, are accounted for using the equity method of accounting, whereby the investment is carried at cost of acquisition, plus the Company’s equity in undistributed earnings or losses since acquisition.

Going Concern

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. However, the Company has reported a net loss of $9,352,872 for the six months ended June 30, 2008, accumulated deficit of $100,168,651 and a working capital deficit of $5,335,870 as of June 30, 2008.

The Company believes that anticipated revenues from operations will be insufficient to satisfy its ongoing capital requirements for at least the next 12 months.  If the Company’s financial resources are insufficient, the Company will require additional financing in order to execute its operating plan and continue as a going concern. The Company cannot predict whether this additional financing will be in the form of equity or debt, or be in another form. The Company may not be able to obtain the necessary additional capital on a timely basis, on acceptable terms, or at all.  In any of these events, the Company may be unable to implement its current plans for expansion, repay its debt obligations as they become due, or respond to competitive pressures, any of which circumstances would have a material adverse effect on its business, prospects, financial condition and results of operations.
 
7
 
Management plans to take the following steps that it believes will be sufficient to provide the Company with the ability to continue as a going concern. Management intends to raise capital through asset-based financing and/or the sale of its stock in private placements.  Management believes that with this financing, the Company will be able to generate additional revenues that will allow the Company to continue as a going concern. There can be no assurance that the Company will be successful in obtaining this additional funding.

Concentrations of Credit Risk

Financial instruments and related items, which potentially subject the Company to concentrations of credit risk, consist primarily of cash and cash equivalents. The Company places its cash and temporary cash investments with credit quality institutions. At times, such investments may be in excess of the FDIC insurance limit. The allowance for doubtful accounts was $190,306 and $111,957 at June 30, 2008 and December 31, 2007, respectively.

Investments

Telkonet maintained investments in two publicly-traded companies for the six months ended June 30, 2008.  The Company has classified these securities as available for sale.  Such securities are carried at fair market value.  Unrealized gains and losses on these securities, if any, are reported as accumulated other comprehensive income (loss), which is a separate component of stockholders’ equity.  Unrealized losses of $1,558,204 were recorded for the six months ended June 30, 2008 and there were no unrealized gains or losses for the six months ended June 30, 2007.  Realized gains and losses and declines in value judged to be other than temporary on securities available for sale, if any, are included in operations.  There were no realized gains or losses for the six months ended June 30, 2008 and 2007, respectively.

Liquidity

As shown in the accompanying consolidated financial statements, the Company incurred net losses of $9,352,872 and $9,986,346 for the six months ended June 30, 2008 and 2007, respectively. The Company's current liabilities, on a consolidated basis, exceeded its current assets by $5,335,870 as of June 30, 2008.

Revenue Recognition

For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB104”), which superseded Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (“SAB101”). SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectibility of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The Company defers any revenue for which the product has not been delivered or is subject to refund until such time that the Company and the customer jointly determine that the product has been delivered or no refund will be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable Revenue Arrangements. EITF 00-21 addresses accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.

For equipment under lease, revenue is recognized over the lease term for operating lease and rental contracts. All of the Company’s leases are accounted for as operating leases. At the inception of the lease, no lease revenue is recognized and the leased equipment and installation costs are capitalized and appear on the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of this equipment is depreciated from two to three years, on a straight-line basis down to the Company’s original estimate of the projected value of the equipment at the end of the scheduled lease term. Monthly lease payments are recognized as rental income.

MST accounts for the revenue, costs and expense related to residential cable services as the related services are performed in accordance with SFAS No. 51, Financial Reporting by Cable Television Companies. Installation revenue for residential cable services is recognized to the extent of direct selling costs incurred. Direct selling costs have exceeded installation revenue in all reported periods. Generally, credit risk is managed by disconnecting services to customers who are delinquent. The capitalized cost of this equipment is depreciated from three to ten years, on a straight-line basis down to the Company's original estimate of the projected value of the equipment at the end of the scheduled lease term and appears on the Balance Sheet in "Cable and Related Equipment."
 
8
 
Management identifies a delinquent customer based upon the delinquent payment status of an outstanding invoice, generally greater than 30 days past due.  The delinquent account designation does not trigger an accounting transaction until such time the account is deemed uncollectible. The allowance for doubtful accounts is determined by examining the reserve history and any outstanding invoices that are over 30 days past due as of the end of the reporting period.  Accounts are deemed uncollectible on a case-by-case basis, at management’s discretion based upon an examination of the communication with the delinquent customer and payment history.  Typically, accounts are only escalated to “uncollectible” status after multiple attempts have been made to communicate with the customer.

Revenue from sales-type leases for Ethostream products is recognized at the time of lessee acceptance, which follows installation. The Company recognizes revenue from sales-type leases at the net present value of future lease payments. Revenue from operating leases is recognized ratably over the lease period.

Guarantees and Product Warranties

FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee.

The Company’s guarantees were issued subject to the recognition and disclosure requirements of FIN 45 as of June 30, 2008 and December 31, 2007. The Company records a liability for potential warranty claims. The amount of the liability is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made. During the six months ended June 30, 2008 and the year ended December 31, 2007, the Company experienced approximately three percent of units returned. As of June 30, 2008 and December 31, 2007, the Company recorded warranty liabilities in the amount of $130,883 and $102,534, respectively, using this experience factor.

Reclassifications

Certain reclassifications have been made in prior year's financial statements to conform to classifications used in the current year.

Registration Payment Arrangements

The Company accounts for registration payment arrangements under Financial Accounting Standards board (FASB) Staff Position EITF 00-19-2, “Accounting for Registration Payment Arrangements” (FSP EITF 00-19-2). FSP EITF 00-19-2 specifies that the contingent obligation to make future payments under a registration payment arrangement should be separately recognized and measured in accordance with SFAS No. 5, Accounting for Contingencies. FSP EITF 00-19-2 was issued in December, 2006.  As of December 31, 2007, the Company had accrued an estimated penalty (see Note E).

On February 11, 2008, the investors executed a letter agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated damages under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65.  Therefore the Company has reversed the accrued expense for the potential liquidated damages during the six months ended June 30, 2008.

Derivative Financial Instruments
 
The Company's derivative financial instruments consist of embedded derivatives related to the Convertible Debentures entered into in May 2008. These embedded derivatives include certain conversion features, variable interest features, call options and default provisions. The accounting treatment of derivative financial instruments requires that the Company record the derivatives and related warrants at their fair values as of the inception date of the Note Agreement (estimated at $1,286,759) and at fair value as of each subsequent balance sheet date. In addition, under the provisions of EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock," as a result of entering into the Notes, the Company is required to classify all other non-employee stock options and warrants as derivative liabilities and mark them to market at each reporting date. The fair value of such options and warrants that were reclassified as liabilities from additional paid-in capital in the period ended June 30, 2008 totaled $2,305,211.

 The Company uses the Black-Scholes Pricing Model to determine fair values of its derivatives. Valuations derived from this model are subject to ongoing internal and external verification and review. The model uses market-sourced inputs such as interest rates, exchange rates and option volatilities. Selection of these inputs involves management's judgment and may impact net income. The fair value of the derivative liabilities are subject to the changes in the trading value of the Company's common stock. As a result, the Company's financial statements may fluctuate from quarter-to-quarter based on factors, such as the price of the Company's stock at the balance sheet date, the amount of shares converted by note holders and/or exercised by warrant holders.  Any change in fair value will be recorded as non-operating, non-cash income or expense at each reporting date. If the fair value of the derivatives is higher at the subsequent balance sheet date, the Company will record a non-operating, non-cash charge. If the fair value of the derivatives is lower at the subsequent balance sheet date, the Company will record non-operating, non-cash income. Conversion-related derivatives were valued using the Black-Scholes Option Pricing Model with the following assumptions: dividend yield of 0%; annual volatility of 82%; and risk free interest rate of 3.14%. The derivatives are classified as long-term liabilities.
 
9
 
New Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board (FASB) issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133 (SFAS 161).  The SFAS 161 requires companies to provide enhanced disclosures regarding derivative instruments and hedging activities and requires companies to better convey the purpose of derivative use in terms of the risks they intend to manage. Disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect a company’s financial position, financial performance, and cash flows are required. This Statement retains the same scope as SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and is effective for fiscal years and interim periods beginning after November 15, 2008. We do not expect the adoption of SFAS No. 161 to have a material impact, if any, on our consolidated financial statements.

In February 2008, the FASB issued a FASB Staff Position (FSP) on Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (FSP FAS 140-3). This FSP addresses the issue of whether the transfer of financial assets and the repurchase financing transactions should be viewed as two separate transactions or as one linked transaction. The FSP includes a rebuttable presumption that the two transactions are linked unless the presumption can be overcome by meeting certain criteria. The FSP will be effective for fiscal years beginning after November 15, 2008 and will apply only to original transfers made after that date; early adoption will not be allowed. We do not expect the adoption of FSP FAS 140-3 to have a material impact, if any, on our consolidated financial statements.
 
NOTE B - ACQUISITION OF SUBSIDIARY

Acquisition of Microwave Satellite Technologies, Inc.

On January 31, 2006, the Company acquired a 90% interest in MST from Frank Matarazzo, the sole stockholder of MST, in exchange for $1.8 million in cash and 1.6 million unregistered shares of the Company’s common stock for an aggregate purchase price of $9,000,000. The purchase price of $9,000,000 was increased by $117,822 for direct costs related to the acquisition. These direct costs included legal, accounting and other professional fees. The cash portion of the purchase price was paid in two installments, $900,000 at closing and $900,000 in February 2007. The stock portion is payable from shares held in escrow, 400,000 shares at closing and the remaining 1,200,000 “purchase price contingency” shares issued based on the achievement of 3,300 subscribers (as defined in Section 2.3 of the purchase agreement) over a three year period. In the year ended December 31, 2006, the Company issued 200,000 shares of the purchase price contingency valued at $900,000 as an adjustment to goodwill.

Additionally, in April 2008, the Company released from escrow 200,000 shares of the purchase price contingency. In June 2008, the Company released from escrow an additional 400,000 shares in exchange for Mr. Matarazzo’s agreement to a debt covenant contained in the transaction documents executed in connection with the debenture financing with YA Global Investments LP which prohibits the use of the proceeds obtained in the debt financing to fund MST.

On May 24, 2007, MST completed a merger transaction pursuant to which it became a wholly-owned subsidiary of MSTI Holdings, Inc. (formerly Fitness Xpress, Inc.), an inactive publicly registered shell corporation with no significant assets or operations. As a result of the merger, there was a change in control of the public shell corporation. In accordance with SFAS No. 141, MST was the acquiring entity. While the transaction is accounted for using the purchase method of accounting, in substance the transaction represented a recapitalization of MST’s capital structure. For accounting purposes, the Company accounted for the transaction as a reverse acquisition and MST is the surviving entity. MST did not recognize goodwill or any intangible assets in connection with the transaction. In connection with the acquisition, the Company’s 90% interest in MST was converted to a 63% interest in MSTI Holdings, Inc.  

The purchase price contingency shares are price protected for the benefit of the former owner of MST. In the event the Company’s common stock price is below $4.50 per share upon issuance of the shares from escrow, a pro rata adjustment in the number of shares will be required to support the aggregate consideration of $5.4 million. The price protection provision provides a cash benefit to the former owner of MST if the as-defined market price of the Company’s common stock is less than $4.50 per share at the time of issuance from the escrow. The issuance of additional shares or distribution of other consideration upon resolution of the contingency based on the Company’s common stock prices will not affect the cost of the acquisition. When the contingency is resolved or settled, and additional consideration is distributable, the Company will record the current fair value of the additional consideration and the amount previously recorded for the common stock issued will be simultaneously reduced to the lower current value of the Company’s common stock.
 
10
 
MST is a communications technology company that offers complete sales, installation, and service of Very Small Aperture Terminal (VSAT) and business television networks, and is a full-service national Internet Service Provider (ISP).  Management believes that the MST acquisition will enable Telkonet to provide a complete “Quad-play” solution to subscribers of multichannel video programming, VoIP telephony, NuVision Broadband Internet access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling units and hotels.

The acquisition of MST was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the average price of the Company's common stock for several days before and after the acquisition of MST. The results of operations for MST have been included in the Consolidated Statements of Operations since the date of acquisition. The components of the purchase price were as follows:
 
   
As Reported
    
Including
Purchase
Price Contingency
(*)
  
Common stock
  
$
2,700,000
    
$
7,200,000
  
Cash (including note payable)
    
1,800,000
      
1,800,000
  
Direct acquisition costs
    
117,822
      
117,822
  
Purchase price
    
4,617,822
      
9,117,822
  
Minority interest
    
19,569
      
19,569
  
Total
  
$
4,637,391
    
$
9,137,391
  

In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

   
As Reported
    
Including
Purchase
Price Contingency
 (*)
  
Cash and other current assets
  
$
346,548
    
$
346,548
  
Equipment and other assets
    
1,310,125
      
1,310,125
  
Subscriber lists
    
2,463,927
      
2,463,927
  
Goodwill
    
1,977,767
      
6,477,767
  
Subtotal
    
6,098,367
      
10,598,367
  
Current liabilities
    
1,460,976
      
1,460,976
  
Total
  
$
4,637,391
    
$
9,137,391
  

(*) At the date of the acquisition, the effect of the “purchase price contingency” shares valued at approximately $5.4 million had not been recorded in accordance with FAS 141. In the second quarter of 2006, the Company issued 200,000 shares of the purchase price contingency valued at $900,000 as an adjustment to goodwill. The remaining shares, when issued, will reflect an adjustment to goodwill and other intangibles.

Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The Company used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a period of eight years. Expected costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows. In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually. The subscriber list was valued at $2,463,927 with an estimated useful life of eight years.
 
11
 
The acquisition of MST resulted in the valuation of MST’s subscriber lists as intangible assets. The MST subscriber list was determined to have an eight-year life. This intangible was amortized using that life, and amortization from the date of the acquisition through December 31, 2007, was taken as a charge against income in the consolidated statement of operations. In accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the intangible asset subject to amortization was reviewed for impairment at December 31, 2007.

Goodwill of $1,977,768, excluding the remaining purchase price contingency, represented the excess of the purchase price over the fair value of the net tangible and intangible assets acquired.  In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually.  At December 31, 2007, the Company performed an impairment test on the goodwill. Based upon management’s assessment of operating results and forecasted discounted cash flow, the carrying value of goodwill was determined to be impaired and therefore the entire value of $1,977,768 was written off during the year ended December 31, 2007.  For the six months ended June 30, 2008, the Company has estimated $380,000 impairment of the carrying value of goodwill issued upon the release of the purchase price contingency escrow.

Acquisition of Smart Systems International, Inc.

On March 9, 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada for cash and Company common stock having an aggregate value of $6,875,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common stock. The Company was obligated to register the stock portion of the purchase price on or before May 15, 2007 and on March 14, 2008 this registration statement was declared effective.  Additionally, 1,090,909 of these shares were held in an escrow account for a period of one year following the closing from which certain potential indemnification obligations under the purchase agreement could be satisfied. The aggregate number of shares held in escrow was subject to adjustment upward or downward depending upon the trading price of the Company’s common stock during the one year period following the closing date.  On March 12, 2008, the Company released these shares from escrow and issued an additional 1,882,225 shares on June 12, 2008 pursuant to the adjustment provision in the SSI asset purchase agreement.

The acquisition of SSI was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the most recent price of the Company's common stock on the day immediately preceding the acquisition date. The results of operations for SSI have been included in the Consolidated Statements of Operations since the date of acquisition.  The components of the purchase price were as follows:

   
As
Reported
  
Common stock
  
$
6,000,000
  
Cash
    
875,000
  
Direct acquisition costs
    
131,543
  
Total Purchase Price
  
$
7,006,543
  
 
In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

Current assets
  
$
1,646,054
  
Property, plant and equipment
    
36,020
  
Other assets
    
8,237
  
Goodwill
    
5,874,016
  
Total assets acquired
    
7,564,327
  
         
Accounts payable and accrued liabilities
    
(557,784
)
Total liabilities assumed
    
(557,784
)
Net assets acquired
  
$
7,006,543
  
 
12
 
Goodwill represents the excess of the purchase price over the fair value of the net tangible assets acquired.  In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually.  We completed our annual impairment testing during the fourth quarter of 2007, and determined that there was no impairment to the carrying value of goodwill.

Acquisition of Ethostream LLC

On March 15, 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition will enable Telkonet to provide installation and support for PLC products and third party applications to customers across North America. The purchase price of $11,756,097 was comprised of $2.0 million in cash and 3,459,609 shares of the Company’s common stock. The entire stock portion of the purchase price is being held in escrow to satisfy certain potential indemnification obligations of the sellers under the purchase agreement. The shares held in escrow are distributable over the three years following the closing.  If during the twelve months following the Closing, the common stock has a volume-weighted average trading price of at least $4.50, as reported on the American Stock Exchange, for twenty (20) consecutive trading days, the aggregate number of shares of common stock issuable to the sellers shall be adjusted such that the number of shares of common stock issuable as the stock consideration shall be determined assuming a per share price equal to $4.50.

The acquisition of Ethostream was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the most recent price of the Company's common stock prior to the acquisition date. The results of operations for Ethostream have been included in the Consolidated Statements of Operations since the date of acquisition.  The components of the purchase price were as follows:

   
As Reported
  
Common stock
  
$
9,756,097
  
Cash
    
2,000,000
  
Direct acquisition costs
    
164,346
  
Total Purchase Price
  
$
11,920,443
  

In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

Current assets
  
$
949,308
  
Property, plant and equipment
    
51,724
  
Other assets
    
21,602
  
Subscriber lists
    
2,900,000
  
Goodwill
    
8,796,440
  
Total assets acquired
    
12,719,074
  
Accounts payable and accrued liabilities
    
(798,631
)
Total liabilities assumed
    
(798,631
)
Net assets acquired
  
$
11,920,443
  

Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The Company used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a period of twelve years. Expected costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows. In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually.

The subscriber list was valued at $2,900,000 with an estimated useful life of twelve years. This intangible was amortized using that life, and amortization from the date of the acquisition through June 30, 2008, was taken as a charge against income in the consolidated statement of operations.
 
13
 
In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually.  We completed our annual impairment testing during the fourth quarter of 2007, and determined that there was no impairment to the carrying value of goodwill.

Acquisition of Newport Telecommunications Co. by Subsidiary

On July 18, 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the Company’s majority owned subsidiary MSTI Holdings Inc., acquired substantially all of the assets of Newport Telecommunications Co., a New Jersey general partnership (“Newport”), relating to Newport’s business of providing broadband internet and telephone services at certain residential and commercial properties in the development known as Newport in Jersey City, New Jersey. Pursuant to the terms of the Newport acquisition, the total consideration paid was $2,550,000, consisting of (i) 866,856 unregistered shares of the Company’s common stock, equal to $1,530,000 (which is based on the average closing prices for the Company common stock for the ten trading days immediately prior to the closing date), and (ii) $1,020,000 in cash.

The acquisition of Newport was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the average closing prices for the Company common stock for the ten trading days immediately prior to the closing date. The results of operations for Newport have been included in the Consolidated Statements of Operations since the date of acquisition.  The components of the purchase price were as follows:

   
As Reported
  
Common stock
  
$
1,530,000
  
Cash
    
1,020,000
  
Direct acquisition costs
    
98,294
  
Total Purchase Price
  
$
2,648,294
  

In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

Current assets
  
$
-
  
Property, plant and equipment
    
668,107
  
Subscriber lists
    
1,980,187
  
Total assets acquired
    
2,648,294
  
Accounts payable and accrued liabilities
    
-
  
Total liabilities assumed
    
-
  
Net assets acquired
  
$
2,648,294
  

Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The subscriber list was valued at $1,980,187 with an estimated useful life of eight years.

The following unaudited condensed combined pro forma results of operations reflect the pro forma combination of the Telkonet, MST, SSI, Ethostream and Newport businesses as if the combination had occurred at the beginning of the periods presented compared with the actual results of operations of Telkonet for the same period. The unaudited pro forma condensed combined results of operations do not purport to represent what the companies’ combined results of operations would have been if such transaction had occurred at the beginning of the periods presented, and are not necessarily indicative of Telkonet’s future results.
 
   
For The Three Months Ended
June 30,
    
For The Six Months
Ended
June 30,
  
   
2008
    
2007
    
2008
    
2007
  
                         
Product revenue
  
$
3,994,329
    
$
2,626,079
    
$
7,369,155
    
$
4,179,961
  
Recurring revenue
    
1,630,208
      
1,571,842
      
3,214,403
      
2,524,921
  
 Total
    
5,624,537
      
4,197,921
      
10,583,558
      
6,704,882
  
                                 
Net (loss)
  
$
(4,231,841
) 
  
$
 (4,249,079
) 
  
$
(9,812,890
) 
  
$
(9,471,309
) 
Basic (loss) per share
    
(0.05
)
    
(0.07
)
    
(0.13
)
    
(0.17
)
Diluted (loss) per share
    
(0.05
)
    
(0.07
) 
    
(0.13
) 
    
(0.17
) 
 
 

14

NOTE C - INTANGIBLE ASSETS AND GOODWILL

As a result of the MST acquisition at January 31, 2006 and the Ethostream acquisition on March 15, 2007 and MST’s acquisition of Newport on July 18, 2007, the Company had intangibles totaling $7,344,114 at June 30, 2008 (Note B).

The Company has adopted Statement of Financial Accounting Standards No. 144 (SFAS 144). The Statement requires that long-lived assets and certain identifiable intangibles held and used by the Company be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Events relating to recoverability may include significant unfavorable changes in business conditions, recurring losses, or a forecasted inability to achieve break-even operating results over an extended period.   The Company has determined that the value of MST’s capitalized cable and related equipment has been impaired based upon management’s assessment of forecasted discounted cash flow from subscriber revenue and has written off $493,512 of its value, based on the lower of the carrying amount or the fair value less costs to sell, for the year ended December 31, 2007.

We used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a determined length of life year. Expected costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows.

We have applied the same discounted cash flow methodology to the assessment of value of the intangible assets of Ethostream, during the acquisition completed on March 15, 2007, for purposes of determining the purchase price.

The MST subscriber list was determined to have an eight-year life. This intangible was amortized using that life and amortization from the date of the acquisition through June 30, 2008 was taken as a charge against income in the consolidated statement of operations.

Total identifiable intangible assets acquired and their carrying values at December 31, 2007 are:

   
Gross
Carrying
Amount
    
Accumulated Amortization
    
Net
    
Residual
Value
    
Weighted Average Amortization Period (Years)
  
Amortized Identifiable Intangible Assets:
                              
Subscriber lists – MST
  
$
4,444,114
    
$
(703,765
)
    
3,740,349
            
8.0
  
Subscriber lists - Ethostream
    
2,900,000
    
$
(191,320
)
    
2,708,680
    
$
-
      
12.0
  
                                         
Total Amortized Identifiable Intangible Assets
    
7,344,114
    
$
(895,085
)
    
6,449,029
      
-
      
9.6
  
Unamortized Identifiable Intangible Assets:
  
None
                                  
Total
  
$
7,344,114
    
$
(895,085
)
    
6,449,029
    
$
-
      
9.6
  

Total identifiable intangible assets acquired and their carrying values at June 30, 2008 are:

   
Gross
Carrying
Amount
    
Accumulated Amortization
    
Net
    
Residual
Value
    
Weighted Average Amortization Period (Years)
  
Amortized Identifiable Intangible Assets:
                              
Subscriber lists – MST
  
$
4,444,114
    
$
(981,523
)
    
3,462,591
            
8.0
  
Subscriber lists - Ethostream
    
2,900,000
    
$
(312,154
)
    
2,587,846
    
$
-
      
12.0
  
                                         
Total Amortized Identifiable Intangible Assets
    
7,344,114
    
$
(1,293,677
)
    
6,050,437
      
-
      
9.6
  
Unamortized Identifiable Intangible Assets:
  
None
                                  
Total
  
$
7,344,114
    
$
(1,293,677
)
    
6,050,437
    
$
-
      
9.6
  
 
15
 
Total amortization expense charged to operations for the six months ended June 30, 2008 was $398,592. Estimated amortization expense as of June 30, 2008 is as follows:

Fiscal
        
July 1 through December 31, 2008
    
398,590
  
2009
    
797,181
  
2010
    
797,181
  
2011
    
797,181
  
2012 and after
    
3,260,304
  
Total
  
$
6,050,437
  

The Company does not amortize goodwill. The Company recorded goodwill in the amount of $1,977,768 as a result of the acquisition of MST during the year ended December 31, 2006, and additional $14,670,455 as a result of the acquisition of Ethostream and SSI during the year ended December 31, 2007 (Note B).  At December 31, 2007, the Company determined that the value of MST’s goodwill has been impaired based upon management’s assessment of operating results and forecasted discounted cash flow and has written off the entire $1,977,768 of its value.  For the six months ended June 30, 2008, the Company has estimated a $380,000 impairment of the carrying value of goodwill issued upon the release of the purchase price contingency escrow.
 
NOTE D - INVENTORIES

Inventories are stated at the lower of cost or market determined by the first-in, first-out (FIFO) method.  Inventories consist of the primary components of the Telkonet iWire System™, which are Gateways, Extenders, iBridges and Couplers, and the primary components of the Telkonet SmartEnergy energy management solution, which are thermostats, sensors and controllers.

Components of inventories as of June 30, 2008 and December 31, 2007 are as follows:

   
2008
    
2007
  
Raw Materials
  
$
643,707
    
$
928,739
  
Finished Goods
    
1,643,941
      
1,649,345
  
Total
  
$
2,287,648
    
$
2,578,084
  
 
NOTE E - SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE

Senior Convertible Debenture

A summary of convertible debentures payable at June 30, 2008 and December 31, 2007 is as follows:

   
June 30,
2008
    
December 31, 2007
  
Senior Convertible Debentures, accrue interest at 13% per annum and mature on May 29, 2011
  
$
1,500,000
    
$
-
  
Debt Discount - beneficial conversion feature, net of accumulated amortization of $20,027 and $0 at June 30, 2008 and December 31, 2007, respectively.
    
(700,939
)
    
-
  
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $15,716 and $0 at June 30, 2008 and December 31, 2007, respectively.
    
(550,077
)
    
-
  
                 
Total
  
$
248,984
    
$
-
  
Less: current portion
    
-
      
-
  
   
$
248,984
    
$
-
  

On May 30, 2008, the Company entered into a Securities Purchase Agreement with YA Global Investments, L.P. (the “Buyer”) pursuant to which the Company agreed to issue and sell to the Buyer up to $3,500,000 of secured convertible debentures (the “Debentures”) and warrants to purchase (the “Warrants”) up to 2,500,000 shares of the Company’s Common Stock, par value $0.001 per share (the “Common Stock”).  The sale of the Debentures and Warrants will be effectuated in three separate closings, the first of which occurred on May 30, 2008, and the remainder of which shall occur after the satisfaction of certain conditions, including, but not limited to, the approval by the Company’s stockholders of an amendment to the Company’s certificate of incorporation authorizing additional shares of Common Stock for issuance.  At the May 30, 2008 closing, the Company sold Debentures having an aggregate principal value of $1,500,000 and Warrants to purchase 2,100,000 shares of Common Stock.
 
16
 
The Debentures accrue interest at a rate of 13% per annum and mature on May 29, 2011.  The Debentures may be redeemed at any time, in whole or in part, by the Company upon payment by the Company of a redemption premium equal to 15% of the principal amount of Debentures being redeemed, provided that an Equity Conditions Failure (as defined in the Debentures) is not occurring at the time of such redemption.  The Buyer may also convert all or a portion of the Debentures at any time at a price equal to the lesser of (i) $0.58, or (ii) ninety percent (90%) of the lowest volume weighted average price of the Company’s Common Stock during the ten (10) trading days immediately preceding the conversion date.  The Warrants expire five years from the date of issuance and entitle the Buyers to purchase shares of the Company’s Common Stock at a price per share of $0.61.

The Debenture meets the definition of a hybrid instrument, as defined in SFAS 133, Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133). The hybrid instrument is comprised of a i) a debt instrument, as the host contract and ii) an option to convert the debentures into common stock of the Company, as an embedded derivative. The embedded derivative derives its value based on the underlying fair value of the Company’s common stock. The Embedded Derivative is not clearly and closely related to the underlying host debt instrument since the economic characteristics and risk associated with this derivative are based on the common stock fair value. The Company has separated the embedded derivative from the hybrid instrument and classified the Embedded Derivative as a liability with an offsetting debit to debt discount, which will be amortized over the term of the debenture based on the effective interest method.

The embedded derivative does not qualify as a fair value or cash flow hedge under SFAS No. 133. Accordingly, changes in the fair value of the embedded derivative are immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in the accompanying statements of operations. There was a loss of $1,478,471 recognized for the period ended June 30, 2008.

The Company determines the fair value of the embedded derivatives and records them as a discount to the debt and a derivative liability on the date of issue. The Company recognizes an immediate financing expense for any excess in the fair value of the derivatives over the debt amount.  Upon conversion of the debt to equity, any remaining unamortized discount is charged to financing expense.

The Company amortized the beneficial conversion feature and the value of the attached warrants, and recorded non-cash interest expense in the amount of $20,027, and $15,716, respectively, for the six months ended June 30, 2008.

Senior Convertible Debentures - MST

A summary of convertible promissory notes payable at June 30, 2008 and December 31, 2007 is as follows:

   
June 30,
2008
    
December 31,
2007
  
Senior Convertible Debentures, accrue interest at 8% per annum commencing on the first anniversary of the original issue date of the debentures, payable quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010
  
$
6,657,872
    
$
6,576,350
  
Original Issue Discount - net of accumulated amortization of $526,894 and $307,038 at June 30, 2008 and December 31, 2007, respectively.
    
(5,978
)
    
(219,312
)
Debt Discount - beneficial conversion feature, net of accumulated amortization of $759,119 and $283,464 at June 30, 2008 and December 31, 2007, respectively.
    
(1,365,450
)
    
(1,174,351
)
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $568,768 and $181,118 at June 30, 2008 and December 31, 2007, respectively.
    
(1,022,929
)
    
(750,347
)
                 
Total
  
$
4,263,515
    
$
4,432,342
  
Less: current portion
    
-
      
-
  
   
$
4,263,515
    
$
4,432,342
  

During the year ended December 31, 2007, MSTI Holdings Inc., issued senior convertible debentures (the "Debentures") having a principal value of $6,576,350 to investors, including an original issue discount of $526,350, in exchange for $6,050,000 from investors, exclusive of placement fees. The original issue discount to the MSTI Debentures is amortized over 12 months. The MSTI Debentures accrue interest at 8% per annum commencing on the first anniversary of the original issue date of the MSTI Debentures, payable quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010. The MSTI Debentures are not callable and are convertible at a conversion price of $0.65 per share into 10,117,462 shares of MSTI Holdings Inc. common stock, subject to certain limitations.  The MSTI Debenture holders are subject to a “Beneficial Ownership Limitation” pursuant to which the number of shares of common stock of MSTI Holdings, Inc. held by such debenture holders immediately following conversion of the MSTI Debenture shall not exceed 4.99% of all of the issued and outstanding common stock of MSTI Holdings, Inc.  The MSTI Debentures are senior indebtedness and the holders of the MSTI Debentures have a security interest in all of MSTI Holdings, Inc.’s assets.
 
17
 
In accordance with Emerging Issues Task Force Issue 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"), MST recognized an imbedded beneficial conversion feature present in the MSTI Debentures. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to the MST additional paid in capital included in the Company’s minority interest. The Company recognized and measured an aggregate of $1,457,815 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the MSTI Debentures issued during the year ended December 31, 2007. The debt discount attributed to the beneficial conversion feature is amortized over the MSTI Debentures maturity period (three years) as interest expense.  On February 11, 2008, the MSTI Debenture holders executed a letter agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated damages under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65.  In connection with this waiver, the Company has recognized an additional $641,294 of debt discount attributed to the beneficial conversion feature for the six months ended June 30, 2008.

In connection with the placement of the MSTI Debentures, MSTI Holdings, Inc. also issued to the MSTI Debenture holders, five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise price of $1.00 per share. MSTI Holdings Inc. valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility of 54%. The $931,465 of debt discount attributed to the value of the warrants issued is amortized over the MSTI Debentures maturity period (three years) as interest expense.  On February 11, 2008, the Debenture holders executed a letter agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated damages under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65.  In connection with this waiver, the Company has recognized an additional $641,294 of debt discount attributed to the value of the warrants issued for the six months ended June 30, 2008.

In connection with the issuance of the MSTI Debentures, MSTI Holdings Inc. incurred placement fees of $423,500. Additionally, MSTI Holdings Inc. issued such agents five-year warrants to purchase 708,222 shares of MSTI Holdings Inc. common stock at an exercise price of $1.00.

During the six months ended June 30, 2008, MSTI Holdings Inc. issued additional convertible debentures with a principal value of $81,522 to existing note holders with a maturity date of April 30, 2010.  In connection with this debenture, the Company has recognized an additional $6,522, $25,460 and $18,938 of debt discount attributed to the original issue discount, the beneficial conversion feature and the value of the attached warrants for the six months ended June 30, 2008.

The Company amortized the original issue discount, the beneficial conversion feature and the value of the attached warrants, and recorded non-cash interest expense in the amount of $219,856, $475,655, and $387,650, respectively, for the six months ended June 30, 2008.

Registration Rights Liquidated Damages

On May 24, 2007, MSTI Holdings, Inc. completed a private placement, pursuant to which 5,597,664 shares of common stock and five-year warrants to purchase 2,798,836 shares of common stock were issued at an exercise price of $1.00 per share, for total proceeds of $2,694,020.  Additionally, MSTI Holdings, Inc. also sold MSTI Debentures (as previously described) for total proceeds of $6,050,000.  The MSTI Debentures bear interest at a rate of 8% per annum, commencing on the first anniversary of the original issue date of the MSTI Debentures, payable quarterly in cash or common stock, at MSTI Holdings, Inc. option, and mature on April 30, 2010. The MSTI Debentures are not callable and are convertible at a price of $0.65 per share into 10,117,462 shares of MSTI Holdings, Inc. common stock.  In addition, holders of the MSTI Debentures received five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise price of $1.00 per share.

MSTI Holdings, Inc. agreed to file a “resale” registration statement with the SEC within 60 days after the final closing of the private placement and the issuance of the MSTI Debentures covering all shares of common stock sold in the private placement and underlying the MSTI Debentures, as well as the warrants attached to the private placement. MSTI Holdings, Inc. also agreed to use its best efforts to have such “resale” registration statement declared effective by the SEC as soon as possible and, in any event, within 120 days after the initial closing of the private placement and the issuance of the MSTI Debentures.
 
18
 
In addition, with respect to the shares of common stock sold in the private placement and underlying the warrants, MSTI Holdings, Inc. agreed to maintain the effectiveness of the “resale” registration statement from the effective date until the earlier of (i) 18 months after the date of the closing of the private placement or (ii) the date on which all securities registered under the registration statement (a) have been sold, or (b) are otherwise able to be sold pursuant to Rule 144, at which time exempt sales may be permitted for purchasers of the common stock in the private placement, subject to MSTI Holdings right to suspend or defer the use of the registration statement in certain events.

The registration rights agreement requires the payment of liquidated damages to the investors of approximately 1% per month of the aggregate proceeds of $9,128,717, or the value of the unregistered shares at the time that the liquidated damages are assessed, until the registration statement is declared effective.  In accordance with EITF 00-19-2, the Company evaluated the likelihood of achieving registration statement effectiveness.  Accordingly, the Company accrued $500,000 as of December 31, 2007, to account for these potential liquidated damages until the expected effectiveness of the registration statement is achieved.

On February 11, 2008, the investors executed a letter agreement with MSTI Holdings, Inc. waiving their rights to receive liquidated damages under the registration rights agreement, in exchange for a reduction in their warrant exercise price from $1.00 to $0.65.  As a result, the Company has reversed the accrued expense for the potential liquidated damages during the six months ended June 30, 2008.

Senior Note Payable

A summary of the senior notes payable at June 30, 2008 and December 31, 2007 is as follows:

   
June 30,
2008
    
December 31, 2007
  
Senior Note Payable, accrues interest at 6% per annum, and matures on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008.
  
$
-
    
$
1,500,000
  
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $195,924 and $166,744 at June 30, 2008 and December 31, 2007, respectively.
    
-
      
(29,180
)
                 
Total
  
$
-
    
$
1,470,820
  
Less: current portion
    
-
      
1,470,820
  
   
$
-
    
$
-
  

On July 24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ Consultants, Inc. (“GRQ”) pursuant to which the Company issued to GRQ a Senior Promissory Note (the “Note”) in the aggregate principal amount of $1,500,000. The Note was due and payable on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008, and bore interest at a rate of six (6%) percent per annum. The Company incurred approximately $25,000 in fees in connection with this transaction. The net proceeds from the issuance of the Note were for general working capital needs.  On February 8, 2008, this note was repaid in full including $49,750 in accrued but unpaid interest from the issuance date through the date of repayment.

In connection with the issuance of the Note, the Company also issued to GRQ warrants to purchase 359,712 shares of common stock at $4.17 per share. These warrants expire five years from the date of issuance. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 4.00%, a dividend yield of 0%, and volatility of 76%. The $195,924 of debt discount attributed to the value of the warrants issued is amortized over the note maturity period (six months) as non-cash interest expense. The Company amortized the value of the attached warrants, and recorded non-cash interest expense in the amount of $29,180, respectively, during the six months ended June 30, 2008.

Aggregate maturities of long-term debt as of June 30, 2008 are as follows:

For the twelve months ended June 30,
  
Amount
  
2009
  
$
-
  
2010
    
6,657,872
  
2011
    
1,500,000
  
   
$
8,157,872
  
 
19
 
NOTE F – RELATED PARTY ADVANCES

On May 6, 2008, Telkonet executed a Promissory Note in the aggregate principal amount of $400,000.  The Note was due and payable on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) November 6, 2008.  In connection with the issuance of the Note, the Company issued warrants to purchase 800,000 shares of Telkonet common stock at $0.60 per share.  These warrants expire five years from the date of issuance. As of June 30, 2008, the outstanding amount due was $200,000. 

Additionally, a $291,000 income tax refund for certain carry back tax losses of MST for the period prior to the Company’s acquisition is payable to Frank Matarazzo.

From time to time the Company may receive advances from certain of its directors and officers to meet short term working capital needs.  These advances may not have formal repayment terms or arrangements.  As of June 30, 2008, there was $200,000 due to a former member of the Board of Directors of the Company.

NOTE G - FACTORING AGREEMENT

In February 2008, the Company entered into a factoring agreement to sell, without recourse, certain receivables to an unrelated third party financial institution in an effort to accelerate cash flow.  Under the terms of the factoring agreement the maximum amount of outstanding receivables at any one time is $2.5 million.  Proceeds on the transfer reflect the face value of the account less a discount.  The discount is recorded as interest expense in the Consolidated Statement of Operations in the period of the sale.  Net funds received reduced accounts receivable outstanding while increasing cash.  Fees paid pursuant to this arrangement are included in “Financing expense” in the Consolidated Statement of Operations and amounted to $110,234 for the six months ended June 30, 2008.
 
NOTE H - CAPITAL STOCK

The Company has authorized 15,000,000 shares of preferred stock, with a par value of $.001 per share. As of June 30, 2008, and December 31, 2007, the Company has no preferred stock issued and outstanding. The Company has authorized 130,000,000 shares of common stock, with a par value of $.001 per share. As of June 30, 2008, and December 31, 2007, the Company has 80,168,105 and 70,826,544 shares, respectively, of common stock issued and outstanding.

During the six months ended June 30, 2008, the Company amended certain stock purchase warrants held by private placement investors to reduce the exercise price under such warrants from $4.17 per share to $0.6978258 per share.  The warrants entitled the holders to purchase an aggregate of up to 3,380,000 shares of Telkonet common stock.   Subsequently, these private placement investors exercised all of their warrants on a cashless basis using the a five day volume average weighted price (VWAP) as of January 31, 2008 of $.99 resulting in the issuance of 1,000,000 shares of Company common stock.

During the six months ended June 30, 2008, the Company issued 312,911 shares of common stock to consultants for services performed.  These shares were valued at $340,407, which approximated the fair value of the shares issued during the period services were completed and rendered.

During the six months ended June 30, 2008, Telkonet completed a private placement with one investor for aggregate gross proceeds of $1.5 million.  Pursuant to this private placement, the Company issued 2,500,000 shares of common stock valued at $0.60 per share.

During the six months ended June 30, 2008, Telkonet issued an additional 3,046,425 shares of its common stock to the sellers of Geeks on Call America, Inc. to satisfy the adjustment provision in the stock purchase agreement dated October 19, 2007 (Note K).

During the six months ended June 30, 2008, Telkonet issued an additional 1,882,225 shares of its common stock to the sellers of Smart Systems International (SSI), to satisfy the adjustment provision in the purchase agreement dated March 9, 2007 (Note K).

During the six months ended June 30, 2008, Telkonet issued 600,000 shares of its common stock to Frank T. Matarazzo pursuant to the stock purchase agreement between Telkonet and MST, dated January 31, 2006 (Note K).
 
20
 
NOTE I - STOCK OPTIONS AND WARRANTS

Employee Stock Options
 
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under a non-qualified employee stock option plan.

Options Outstanding
  
Options Exercisable
 
Exercise Prices
  
Number
Outstanding
  
Weighted
Average
Remaining
Contractual
Life
 (Years)
  
 
Weighted
Average
Exercise
Price
  
Number
Exercisable
  
 
Weighted
Average
Exercise
Price
  
$1.00 - $1.99
  
4,378,429
  
4.78
  
$1.03
  
4,121,929
  
$1.00
  
$2.00 - $2.99
  
1,593,000
  
6.50
  
$2.51
  
1,410,000
  
$2.49
  
$3.00 - $3.99
  
1,569,000
  
6.79
  
$3.30
  
1,058,250
  
$3.36
  
$4.00 - $4.99
  
127,500
  
6.71
  
$4.39
  
87,500
  
$4.42
  
$5.00 - $5.99
  
135,000
  
6.61
  
$5.24
  
83,750
  
$5.23
  
     
7,802,929
  
5.60
  
$1.92
  
6,761,429
  
$1.78
  

Transactions involving stock options issued to employees are summarized as follows:

   
Number of
Shares
    
Weighted
Average
Price
Per Share
  
Outstanding at January 1, 2006
    
10,151,078
    
$
1.85
  
Granted
    
1,125,000
      
3.01
  
Exercised
    
(2,051,399
)
    
1.30
  
Cancelled or expired
    
(703,750
)
    
2.67
  
Outstanding at December 31, 2006
    
8,520,929
    
$
2.06
  
Granted
    
935,000
      
2.55
  
Exercised
    
(118,500
)
    
1.05
  
Cancelled or expired
    
(1,232,000
)
    
3.00
  
Outstanding at December 31, 2007
    
8,105,429
    
$
1.98
  
Granted
    
160,000
      
1.00
  
Exercised
    
-
      
-
  
Cancelled or expired
    
(462,500
)
    
2.76
  
Outstanding at June 30, 2008
    
7,802,929
    
$
1.92
  

The weighted-average fair value of stock options granted to employees during the six months ended June 30, 2008 and 2007 and the weighted-average significant assumptions used to determine those fair values, using a Black-Scholes option pricing model are as follows:

   
2008
    
2007
  
Significant assumptions (weighted-average):
            
Risk-free interest rate at grant date
    
3.0%
 
    
4.7%
 
Expected stock price volatility
    
74%
 
    
70%
 
Expected dividend payout
    
-
      
-
  
Expected option life (in years)
    
5.0
      
5.0
  
Expected forfeiture rate
    
12.0%
 
    
12.0%
 
Fair value per share of options granted
  
$
0.62
    
$
1.61
  

The expected life of awards granted represents the period of time that they are expected to be outstanding. We determine the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting forfeitures. We estimate the volatility of our common stock based on the calculated historical volatility of our own common stock using the trailing 24 months of share price data prior to the date of the award. We base the risk-free interest rate used in the Black-Scholes-Merton option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award. We have not paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected to vest. In accordance with SFAS No. 123R, we adjust share-based compensation for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.
 
21
 
The total intrinsic value of the options exercised for the six months ended June 30, 2007 was $94,340. There were no options exercised during the six months ended June 30, 2008.  Additionally, the total fair value of shares vested during the six months ended June 30, 2008 and 2007 was $428,630 and $661,611, respectively.

Total stock-based compensation expense recognized in the consolidated statement of earnings for the six months ended June 30, 2008 and 2007 was $696,025 and $661,611, respectively, net of tax effect. Additionally, the aggregate intrinsic value of options outstanding and unvested as of June 30, 2008 is $0.

Non-Employee Stock Options

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to the Company consultants. These options were granted in lieu of cash compensation for services performed.

Options Outstanding
  
Options Exercisable
Exercise Prices
  
 
Number
Outstanding
  
Weighted
Average
Remaining
Contractual
Life (Years)
  
Weighted
Average
Exercise Price
  
 
Number
Exercisable
  
Weighted
Average
Exercise Price
$1.00
  
1,815,937
  
 3.84
  
$1.00
  
1,815,937
  
$1.00

Transactions involving options issued to non-employees are summarized as follows:

   
Number of
Shares